7. Rydex|SGI

Rydex|SGI is a forward-thinking asset-management firm that provides high quality, innovative investment solutions across the asset allocation spectrum, and is dedicated to meeting investors’ diverse and evolving needs. The firm helps investors and investment advisors maximize the value of their investing tools and strategies, and it works at providing an outstanding level of customer service. In addition to alternative investment and index-based strategies, it offers a broad line of investment solutions, including actively managed global-, value-, growth-, and fixed-income strategies. Rydex|SGI manages assets through more than 140 mutual funds and exchange-traded products. Many of its securities have been successful and helpful, including currencies and equal-weighted ETFs.

Asset Allocation—Modern Portfolio Theory (MPT)

Anthony Davidow is the managing director and portfolio strategist of Rydex|SGI. When asked if asset allocation still makes sense for investors, Davidow says, “I continue to believe in the merits of Modern Portfolio Theory, but recognize that MPT needs to evolve. I don’t think it is obsolete, but the world has certainly changed pretty dramatically over the years. Harry Markowitz and Bill Sharpe helped shape the way we invest. They taught us about the value of diversification, and how to measure risk. In 1990, Markowitz and Sharpe both won the Nobel Prize in economics for their research.”

Davidow says that MPT traces its roots to Harry Markowitz. In June 1952, the 25-year-old graduate student published a paper in the Journal of Finance that would have a profound impact on MPT. His paper on “Portfolio Selection” received little notice at the time, but would help him win the Nobel Prize in Economics in 1990. Markowitz’s paper discussed risk management through diversification. He suggested that in constructing a portfolio of two risky investments with low historical correlation, an investor could reduce the risk of the overall portfolio. Although this seems practical today, this notion of risk reduction through diversification was cutting edge at the time.

Building on Markowitz’s work, Davidow says Bill Sharpe took MPT to the next level with the introduction of the Capital Asset Pricing Model (CAPM). CAPM is a model that describes the relationship between risk and expected return, which also introduced beta as a measure of market risk.

The general premise of MPT is to provide diversification advantages through investments that exhibit a low correlation to one another, which leads advisors to consider alternative investments. In periods of duress, the markets experience significant downward pressure. Davidow argues that fear and greed drive the market as opposed to underlying fundamentals.

Davidow says that after 2008, a lot of people asked, “‘How come asset allocation and MPT didn’t work?’ I would argue that the market is more efficient over the long run, but in periods of ‘shocks’ to our system, it breaks down. When there are shocks to the financial markets, they don’t always react in a rational way. Also, during severe shocks, the correlations among investments tend to be higher than normal. We may experience more shocks in the future, due to the inter-connectivity of the global markets.”

Davidow says that after 2008, advisors are thinking differently about investing their clients’ portfolios. The same old way of investing and thinking about the market doesn’t work. Many advisors have become more tactical and opportunistic, and alternative investments have been deployed to dampen overall portfolio volatility.

Davidow argues that in these periods of market shocks, alternative investments weathered the storm better than traditional investments. Davidow says that much of Markowitz’s work regarding MPT consisted of stocks, bonds, and cash. We live in a much more complex world today, he says, where we divide our traditional investments among large-cap and small-cap, value and growth, and developed and emerging countries. This causes investors to consider many more variables when making decisions. Davidow says, “Modern Portfolio Theory is not obsolete, but it clearly needs to evolve. With the proliferation of business news networks like CNBC, we have shortened the time frame to dissect, analyze, and respond to information. The global nature of the markets makes us more connected than ever.”

Davidow thinks that the markets are set up for more shocks to the system because the flow of information is so much more rapid. He points out that European debt concerns have had a great impact on the U.S. markets. The Japanese tsunami had a ripple effect around the globe. The U.S. markets have reacted to concerns regarding Greece’s potential default and potential contagion among the PIIGS (Portugal, Italy, Ireland, Greece, and Spain). “It’s the new normal,” he says, “and if you have a long-term strategy and you believe there will be shocks, you need to be equipped to deal with shocks.”

Davidow says that advisors are changing the way they invest their clients’ portfolios. Many advisors have taken discretion over their client accounts, so they can respond more adeptly to market changes. Advisors have also expanded their range of solutions offered to clients, and the use of alternative investments has grown to become more mainstream.

Alternative investments represent an evolutionary step, he says. Alternative investments represent a broad array of strategies, including long-short, event-driven, managed futures, private equity, commodities, and global macro among others. They typically offer different risk and return characteristics and often exhibit lower correlation to traditional investments.

Currencies as an Asset Class

Currencies represent an interesting investment option. For a long time used mostly by institutions and hedge funds, currencies represent a means of hedging international exposure and/or opportunistically taking advantage of currency fluctuations. The currency market is the largest and most liquid market in the world, with about $4 trillion in assets being traded worldwide every day. Currencies have mostly been traded by hedge funds and institutions, but have gained broader acceptance by advisors and investors.

According to Davidow, many currencies have historically exhibited low correlation to traditional asset classes such as equity and fixed income. Currencies may serve as a complement to traditional investments and may help lower a portfolio’s volatility. Currencies can be used in a number of ways, such as speculating on future price movements or hedging exposure to a particular market. They can also be used to diversify cash holdings.

Rydex|SGI offers nine currency exchange traded products (ETPs) called CurrencyShares. CurrencyShares offer investors access to a broad array of currencies in a cost-effective exchange-traded structure. CurrencyShares are grantor trusts that hold foreign currency deposits in a segregated account, rather than using futures contracts or other proxies that can lead to imprecise tracking of the underlying currency. If there is interest earned from the securities, it accrues daily. After trust expenses are paid, the remaining interest is distributed to shareholders monthly. The most recent launch was a Chinese renminbi ETP.

Currencies Have Many Uses

Davidow says, “Institutions primarily use currencies to hedge their exposure. If an institution is doing business abroad, the institution can insulate the impact of currency movements and hedge with currency securities. Hedge funds use them to hedge exposure, and invest opportunistically.” He gives the example of selling the euro, which has been under a lot of pressure due to Greece and allocating to the Swiss franc or the Australian (Aussie) dollar. The Swiss franc has benefitted from concerns regarding Greece contagion, and the Aussie dollar is a more natural resource and yield play.

Davidow points out that although the currency market is the largest and most liquid market in the world, it has been difficult for the average investor to invest directly in foreign currencies. Davidow says, “We have provided an exchange traded product (ET) structure, which is a more efficient way for the individual to gain exposure to the marketplace. These securities allow individual investors to gain exposure to the underlying currencies.”

Not all currencies makes sense in today’s environment, Davidow points out. The Aussie dollar is one that stands out as an interesting currency. The Aussie dollar is attractive due to the abundance of natural resources in Australia. They have a strong economy and have benefitted from trade with China. The Aussie dollar also provides about a 4 percent yield.

Individuals and Institutions Buy Currencies

Because Rydex|SGI actually buys currencies and places them into a bank account, CurrencyShares track the actual currency price closely, Davidow says, and “more and more, there is a lot of interest in currencies coming from advisors and individual investors. In my discussions with advisors, the light bulb goes off and people say, ‘I know I need to own currencies but don’t exactly know how to invest.’”

Davidow explains that for many years, hedge funds and institutions had put on the “carry-trade.” He says, “The carry-trade is essentially buying the highest-yielding currency, often the Aussie dollar, and shorting the lowest-yielding currency, often the Japanese yen. But the average investor was trying to figure, ‘How would I do that?’ With CurrencyShares, now any investor can easily put on those trades.”

An Equal-Weighted Way of Owning the Market

Rydex also offers a series of equal-weight ETFs. Davidow says that equal-weight indexes might provide better risk-adjusted results than cap-weighted indexes. He points to the S&P 500 Equal Weight Index, which has historically outperformed their market-cap-weight equivalents.

“Equal weight offers a different way of owning the market,” says Davidow. “I find it fascinating that many people don’t really understand what they own when they own cap-weighting strategies. Most people just accept that if they want to own ‘the market,’ they buy the S&P 500 Index. Nobody asked what you own and how you own it.” Davidow says if you strip down the S&P 500 Index, you can see that the top ten names represent nearly 20 percent of the portfolio, and the top 50 names represent 50 percent of the portfolio.

That means that you are making a concentrated bet by buying a cap-weighted portfolio, Davidow points out and says, “If you believe that those names are the best names to own, why don’t you just buy 50 names?”

Davidow says that he believes that equal weighting gives each name an equal opportunity to perform and contribute to returns over time. “What we found as we looked at our equal-weight strategy is that there are some common characteristics. Equal weighting has shown better risk-adjusted results, not surprisingly, because we diversify our risk across the portfolio.” He says they are finding a true value coming from diversification and that academic research suggests there is a small-cap and mid-cap effect in that small-caps and mid-caps have delivered better results over time. With equal-cap weighting, the small- and mid-cap stocks have the same weighting as big-cap stocks, giving an equal emphasis to the smaller names.

The Value of Equal-Weight Indexes and ETFs

Rydex says that equal-weight indexes reduce the concentration risk usually associated with cap-weight indexes by not being over- concentrated in the biggest cap-weighted companies within the index. Equal-weight indexes own the same companies as the similar indexes that are cap-weighted, but each company in the index has an equal weight. Equal-weighted proponents, such as Davidow, believe this is a rational allocation of components, rather than making concentrated bets on the largest companies merely because they are larger. Davidow says, “Based on our analysis, many equal-weighted indexes retain their benefits across both cap-size indexes and geographic regions.” Equal-weight sector indexes own the underlying companies equally. Equal weighting removes the impact of a few heavyweight stocks dominating the index.

To retain the integrity of equal weighting, portfolios are regularly rebalanced back to equal weights, thereby providing a more dynamic and disciplined approach. This systematic weighting approach might offer broader exposure to sources of market return and help avoid some of the problems related to concentration.

He also thinks that rebalancing, which Rydex does quarterly, is important for performance. “We see a true value in this disciplined rebalancing,” Davidow says. “The disciplined rebalancing allows us to respond to changes in the market place. On a quarterly basis, we rebalance back to equal weight, trimming the companies that have appreciated, and we reallocate to those companies that have lagged. In 1998 and 1999, the markets were dominated by technology stocks; it was at the peak of the dot-com bubble. Those big tech names grew and grew until technology represented about 35 percent of the S&P 500. In 2000, the Tech Bubble burst, and we all know what happened to technology stocks.”

Davidow says, “If we define ‘the market’ as being the cap-weighted S&P 500 Index, our results have been substantially better.” He points out that since the release of the Rydex S&P 500 Equal Weight ETF (symbol RSP) in 2003, it has outperformed cap weighting by a substantial amount.

Equal-Weighted Sector ETFs

Davidow says that there has been increased interest in sector strategies. Sector strategies allow investors to over-weight their favorite sectors and under-weight those that appear overvalued. They can deconstruct the market or use sectors to complement their core exposure. Investors can choose to allocate to either cap-weighted or equal-weight sector strategies. Davidow says equal-weight sector indexes have much different exposure than cap-weighted sector ETFs.

Davidow says, “For example, many people want exposure to energy. The top five names in the cap-weighted energy index represent 60 percent of the energy sector, and the top two names represent 40 percent of the index. Do you believe that those two names represent the entire energy sector? Or, do you believe that you would be better served with broad-based exposure such as drillers, refiners, and coal and natural gas companies?”

Davidow says that when investors see where they get exposure in cap weighting they can determine whether it makes sense to invest in an equal-weighted or cap-weighted fashion. “It is startling to sit down with people and go over this,” Davidow says. “People don’t know they are taking on so much concentration when they are buying a cap-weighted S&P 500 Index sector.”

Davidow thinks that the world is more complex today than in any time in our history. There are more investment options and a much more rapid flow of information. The basic tenets of MPT still make sense; however, MPT needs to evolve to meet the new realities. Investors need to consider a broader array of strategies and determine how to combine them to meet their long-term needs and objectives. It is both a challenging and fascinating investment world that we live in, leading investors to seek innovative strategies and solutions.